U.S.-China joint ventures could be key to closing the federal budget deficit

Many believe U.S.-China joint ventures are doomed to fail, but that is not the case. On the contrary. They may also hold the key to dragging China out of the middle income trap, while helping to close our federal budget deficit. All this has a long history.

In 1860, Chinese scholar Feng Guifen wrote, “what we then have to learn from the [foreigners] is only one [sic] thing, solid ships and effective guns…the intelligence and wisdom of the Chinese are necessarily superior to those of the various [foreigners].” Jonathan Spence – Sterling Professor of History Emeritus at Yale University and author of “The Search for Modern China” – points out, “the conclusion was clear: China would first learn from foreigners, then equal them, and finally surpass them.”

Many attribute China’s lack of innovation to its risk-averse culture. That is to say by reluctance to inquire, questionable quality of tertiary education, and lack of investment in research and development (R&D). The tool China is employing to close this gap is the joint venture, and it is appealing to U.S. companies to serve as the counterparty in many of these joint venture transactions.

Innovation is a key pillar of China’s national agenda, which its leaders view as essential to circumvent the middle income trap. In other words, as wages rise and the Renminbi appreciates, China is finding itself no longer competitive with Vietnam, Mexico, and even some southeastern U.S. states as a low cost exporter. To avoid being trapped in the middle, unable to compete effectively on price or function, China has looked to its current wave of joint ventures to drive its economy “up-market.” More specifically, this should result in investment being redistributed away from China’s infrastructure and into its people and R&D. If this initiative is successful, these ventures will develop products that appeal to and assuage the quality and safety concerns of international buyers, while igniting domestic consumption, particularly among the Chinese middle class.

For the U.S., in the near-term, this means incremental tax revenue via U.S. companies participating in those joint ventures. In the longer-term, it could help grow and unlock a massive export market for U.S. goods. Together these factors would increase government revenue and equalize the trade imbalance, helping to close the federal budget deficit.

Many view U.S.-China joint ventures skeptically, but there are clear examples of those that deliver benefits to both sides. Let’s take one as an anecdote – the IBM-Lenovo alliance and acquisition that closed in 2005. In that transaction, IBM sold its personal computer (PC) business to Lenovo for cash and equity in the new Lenovo – effectively forming a joint venture. IBM was able to strengthen its relationships in China as evidenced by the commercially significant endorsement of one of its technologies by the Chinese Academy of Sciences, while divesting a low margin business and generating significant cash for other opportunities. Lenovo, for its part, received world class PC technology and a large customer base.

This was a mutually beneficial transaction as indicated by the performance of their stock prices relative to the appreciation of their respective markets. Obviously, there is noise in such a broad indicator, but it is worth quick consideration. From November 1, 2004, pre-deal announcement, to today, on a basis adjusted for dividends and splits, IBM’s stock price rose roughly 50 percent more than the broader U.S. market as measured by the S&P 500. Similarly, but more pronounced, Lenovo’s stock price rose roughly two and a half times more than the broader Chinese market as measured by the FTSE China 25 Index.

Given past successes such as IBM’s and Lenovo’s and the position of China as the most populous nation on earth, companies such as General Electric, Honeywell, DreamWorks, AES, Peabody Energy, and Westinghouse are eager to participate in the latest round of joint ventures in China. The question is whether in addition to delivering benefits to all of the companies involved, will these transactions drag China out of the middle income trap and create a mega-consumer – one that concomitantly helps to equalize the U.S.-China trade imbalance? Re-initiated with President Nixon’s overtures to Chairman Mao in 1972, the relationship between the two largest economies in the world may evolve from one of U.S. treasuries for Chinese goods to a more balanced one that helps China move up-market and the U.S. close its budget deficit.

Baynham is a Booz & Company alumnus, who has helped negotiate, launch, and restructure numerous joint ventures both inside and outside of China. Worsthorne is the former editor of The Sunday Telegraph and former Washington correspondent for The Times.